Dividend Sector Sweet Spot In ETFs

Lawrence McDonald is founder of consulting firm The Bear Traps Report and was formerly managing director, head of U.S. strategy, Macro Group at Societe Generale, based in New York. At the height of the 2008 financial crisis, he wrote a book on the fall of Lehman Brothers, "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers." In the book, McDonald details his experience working as vice president at Lehman Brothers in New York, and provides a behind-the-scenes look on why one of the most prominent investment banks failed.

He talked with ETF.com about the sweet spot his firm sees in the dividend space, and how President Trump is going to combat higher interest rates that will benefit the homebuilding market. McDonald is giving the closing keynote speech Nov. 14 at the Inside Fixed Income & Dividend Investing Summit.

Larry McDonald: The first thing I'm going to look at is dividends and a rising yield environment. Certain areas are more vulnerable than others, like REITS, for example, because of the drawdown in certain parts of the country with, say, the Sears of the world. So REITS are getting the double whammy, because they're getting interest rate risk as well as credit risk from major anchor tenants like Sears.

Within fixed income, there are different areas to play dividends that offer better risk/reward than others. Telecom, for example, offers much better risk/reward. Telecom is coming out of a seven-year bear market.

Another area is convertible bonds in this market. I created convertbond.com … convertible bond dividend funds offer better risk/reward.

ETF.com: Why are convertible bonds so attractive to you? They carry risk.

McDonald: Yes, they do. But with a convertible bond fund in a bear market, you're going to outperform on the drawdown, and you're going to underperform on the upside. They provide bond flow there in a fund.

So here’s the thing: Consumer staples are big dividend payers and a better indicator than the yield curve for a recession. Staples start to outperform consumer discretionary at about six to nine months before the recession. You get phenomenal asset wealth protection in a dividend-producing staples stock, relative to other parts of the market.

ETF.com: What ETFs do you use for this investment thesis?

McDonald: The Consumer Staples Select Sector SPDR Fund (XLP). There are certain dividend companies that perform well in, let’s say a growth environment, with higher bond yields, and there are certain dividend companies that perform poorly in a higher-bond-yield environment. So you want to look for the sustainable portfolio that’s more sustainable to higher yield.

ETF.com: What does that look like?

McDonald: It’s more in the staples side. It’s more of the value companies that can grow during a slowdown that’s driven by interest rates. Some of the homebuilding stocks, like the homebuilding ETFs [the SPDR S&P Homebuilders ETF (XHB), the iShares U.S. Home Construction ETF (ITB)] that owned things like Masco, Mohawk. There are areas of the market that can grow in a higher-yield environment.

ETF.com: How does a homebuilder grow in a higher-yield environment? It seems contradictory.

McDonald: Because yields have risen so much, they’ve been destroyed. These stocks are down 35-40%.

But here’s the other thing. Because Powell has backed up rates so much, Trump is trying to figure out how we can offset the higher yields. Look at autos and homes. Think of what percentage of GDP is in the automobile and the home: 40%. These two sectors are being annihilated. GM is down 30% in three months.

Mel Watt, right now, controls the FHFA [Federal Housing Finance Agency]. He’s getting pushed out in January. The White House is going to have [Treasury Secretary] Steve Mnuchin take control over the FHFA. The goal is to expand the credit box. And that means that mortgages—and this might scare you—like the Fannie and Freddie portfolio, will expand. Credit expansion will help the homebuilders in a rising-yield environment.

ETF.com: Are you saying the credit standards will go down while the yields go up?

McDonald: Yes. Not to 2006 or 2007 levels, but the average FICO score on homeownership versus autos is the widest spread ever. So what’s happening is extremely tight standards on homes, relative to autos. It’s the widest it’s ever been, because the lending standards on autos are multidecade lows. But the lending standards on homes, because of Dodd-Frank, are extremely high.

This is Trump’s offset on the rate hikes. I know this firsthand. There’s also speculation that the Trump administration is looking at all kinds of avenues to expand credit availability.